The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Saturday, March 16, 2013

Rather than confiscate insured deposits, could we please fix the global financial system

EU policy makers have crossed the rubicon and decided that insured deposit holders should no longer be protected from the financial performance of the banks, but rather are a source of funds to recapitalize the banks.

With this single action, EU policy makers have undermined the global financial system and dramatically increased its instability.

Why?

Because depositors trusted that their governments would honor their deposit guarantees. They have repeatedly demonstrated this across countries like Greece and Spain where no matter how insolvent their banks looked, the depositors kept their money in the banks out of a belief it was safe.

This is simply no longer true no matter how EU policy makers try to spin it.

The burden is now on depositors to determine if their bank is sitting on losses that the depositor will now have to absorb.

We are about to experience the same response as happened with structured finance securities when investors suddenly discovered that they did not know what they owned. Banks are "black boxes" and structured finance securities are "brown paper bags" when it comes to looking to find out what their underlying exposures are.

Depositors, like structured finance security investors, are going to look for the door.

Why stay and risk the possibility of loss for no return?

As part of confiscating insured deposits in Cyprus, the ECB is standing ready to provide the banks with funds to offset the run that is going to start next Tuesday. So in fairly short order, the ECB will be the primary funding source for the Cyprus banks.

Please note that all of this is avoidable if policy makers stop listening to bankers (who got us into the financial crisis and truly only care about protecting their bonuses) and PhD economists (who frankly don't understand how a bank actually works so they excluded it from their models).

Policy makers have to start listening to individuals like your humble blogger who has a track record that shows they understand what is wrong with the global financial system and what it will take to fix it.

I am on record for "predicting" the financial crisis and with this blog have consistently been accurate when stating what policies will work and what policies will not work as soon as they are mentioned, let alone adopted.

My blueprint for saving the global economy is pretty simple.

First, use the banks as they are designed to be used. Banks are designed to absorb the losses on the excess debt in the financial system and continue to support the real economy.

It is a myth that banks need to be recapitalized immediately after absorbing these losses. Banks are designed to operate with low or negative book capital levels.

Banks can do this because of the combination of deposit insurance and access to central bank funding. Deposit insurance effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels. With taxpayers as a silent equity partner, banks have virtually unlimited "equity" so they can continue to extend credit to support the real economy.

Then, over time, banks can rebuild their book capital levels through retention of 100% of pre-banker bonus earnings.

Call step one: freely spend as much as it takes in future bank earnings to absorb all of the losses on the excess public and private debt in the financial system.

Two, bring transparency back to all the opaque corners of the financial system.

For banks, this means requiring them to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details. With this information, market participants can confirm that the banks have absorbed all the losses on their exposures. With this information, market participants can exert discipline and restrain risk taking by bankers and gambling on redemption.

For structured finance securities, this means requiring observable event based reporting under which all activities like a payment or delinquency on the underlying collateral are reported to market participants before the next business day. Observable event based reporting allows market participants to know what they are buying and know what they own.

Three, use expansionary fiscal policies to kickstart the global economy.

Four, raise interest rates back to the 2% minimum set by Walter Baghot in the 1870s by ending zero interest rate and quantitative easing policies.

This is critical because it ends the ongoing Retirement Plan Death Spiral. Under this spiral, current demand is reduced as savers, both individuals and companies, try to offset the drop in earnings on their investments. Raising rates allows savers to make some money which in turn shows up as current demand.

No matter what the economic models say, raising rates will not discourage business investment. What discourages business investment is lack of demand. This has been proven since the beginning of the financial crisis.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.